Josh Kopelman

Managing Director of First Round Capital.

espite being coastally challenged (currently living in Philadelphia), Josh has been an active entrepreneur and investor in the Internet industry since its commercialization. In 1992, while he was a student at the Wharton School of the University of Pennsylvania, Josh co-founded Infonautics Corporation – an Internet information company. In 1996, Infonautics went public on the NASDAQ stock exchange.

Monthly Archives for 2010

A few weeks back, I wrote a blog post (on Bridge Loans versus Preferred
Equity) that briefly
mentioned the National Venture Capital Association’s Model Legal Documents for
a Venture Capital financing. I am a heavy user of these documents (having
found them to be tremendously valuable in our negotiation process) and thought it would be worth going into some greater detail here.

These documents were drafted to offer a "template" set of public domain model legal documents that are "fair
[and] avoid bias toward the VC or the company/entrepreneur" and reflect "current practices and customs". By providing these documents, the NVCA has
made my job much easier. I routinely use
the NVCA docs as the baseline for First Round Capital's term sheets. Doing so allows me to (1) clearly communicate to
entrepreneurs that I am not looking for any non-standard terms, (2) reduce the legal fees of both parties, and (3) get a deal closed much faster than I would if I had to start from scratch. The documents also note where the East coast and West coast differ in their standard terms - a feature which has been useful as I invest bi-coastally.

A little more about the documents:

The documents were drafted by a working group of law
firms and venture firms and are updated annually. You can check out the current members of the working
group here.

"Annually, our industry closes several thousand
financing rounds, each consuming considerable time and effort on the part of
investors, management teams and attorneys. A conservative estimate is that our
industry spends some $200 million in direct legal fees annually to close
private financing rounds. In an all-too-typical situation, the attorneys start
with documents from a recent financing, iterate back and forth to get the
documents to conform to their joint perspective on appropriate language
(reflecting the specifics of the deal and general industry best practices), and
all parties review numerous black-lined revisions, hoping to avoid missing
important issues as the documents slowly progress to their final form. In other
words, our industry on a daily basis goes through an expensive and inefficient
process of "re-inventing the flat tire." By providing an
industry-embraced set of model documents which can be used as a starting point
in venture capital financings, it is our hope that the time and cost of financings
will be greatly reduced and that all principals will be freed from the time
consuming process of reviewing hundreds of pages of unfamiliar documents and
instead will be able to focus on the high level issues and trade-offs of the
deal at hand."

Over the last year, I've often been asked my thoughts on the re-emergence of the
barter/swap business model. I thought it might be useful to share my perspective here.

Back in the Web 1.0 days, we
saw the rise
and fall of
the barter/swap business model with companies such as WebSwap, Switchouse, Swap.com, SwapVillage,
Mr. Swap, etc). These sites received tens of millions of dollars from well known VCs but none of them were able to gain traction or survive the
fallout. It might be my false pride, but I believe that consumers were
more attracted to person-to-person fixed price sites (such as Half.com and
Amazon Marketplace) where they could swap their CDs/DVDs/Books for cash.
As Forbes magazine wrote in 2000: “It
took humans thousands of years to emerge from the barter system. Does bringing
it back online make sense?”

All of these new sites are looking to build a
barter/swap-based business model. However, the Web 2.0 barter sites represent a meaningful advance from the Web 1.0 barter sites. Rather
than force users to conduct a two-way swap (ie, User A has something that User
B wants AND user B has something that User A wants) they’ve introduced a point
system (or alternate form of currency) to allow users to conduct one-way swaps (ie, User
A gives something to User B for 4 points – and User B can get something from
user C for those points). Users pay a standard fee (typically $1) to make
a trade.

The currency/point model is a
significant improvement. Users can now get something without having to
find someone who wants something from them. Recent blog posts have
compared the efficacy of this new model to the cost of buying/selling used
goods. However, I’m still not convinced that a swap/barter marketplace is as effective as a cash marketplace.

I
spent some time tonight looking at the currency value of DVD’s on
Peerflix. Specifically, I compared the used price of several DVDs on
Half.com to their Peerbux price – and found the values to be highly
disproportional. (I chose Half.com since it is a liquid marketplace that
places a dollar value on used DVD’s – and since I founded it – but the analysis
holds in Amazon Marketplace as well)

For example, you can get both the Fourth and Fifth Season of the
Sopranos on Peerflix for 10 Peerbux each. However, on Half.com you can currently buy the
Fourth Season for $29.99
and the Fifth Season for $38.00. That means that there is an eight dollar price difference between two DVDs worth the same number of Peerbux. So a user who gives away their Fifth Season Sopranos for 10 Peerbux is not just paying a $1 swap
fee – they are leaving another $8 on the table. Moreover, Peerflix users
can buy Peerbux for $5 each. So, if you wanted to get the Fourth Season
of the Sopranos on Peerflix by purchasing Peerbux, you’d be paying $50 – or $20
over market value. Badda bing!

I selected a total a ten DVDs and then computed the implied
cash value of a Peerbuck (by dividing the price on Half.com by the price in
Peerbux).

I was surprised to
see that the price of 1 Peerbuck ranged from $0.95 all the way to $9.30.
This has two consequences. First,
it creates a “winner” and a “loser” in every trade. In a true marketplace, both sides of the transaction get a fair deal. However, if you “sold” your copy of 24 (Season Two) or
Murder by Death on Peerflix you did not get as good as deal as someone who
“sold” their Lord of the Rings or Bad News Bears. By using a point system
instead of real dollars, these marketplaces hide the true cost of the
trade -- and are always putting 50% of their users at a financial disadvantage.

Second, people will want to keep the good DVDs they have, while they're willing to trade the bad ones (via Techdirt). This creates a real arbitrage opportunity. I went on Peerflix and listed several of the
low value items for trade (Lord of the Rings, The Terminal, Sopranos Fourth
Season, Bad News Bears). If I get an
order, I’ll go to Half.com and have the DVD’s shipped to the Peerflix
customer…then I’ll use my new Peerbux to buy Murder by Death or 24 (Second
Season) – and then sell those on Half.com. It should be an interesting experiment – I’ll keep you informed…

You missed your sales forecast. Your CTO quit. You lost a big sales prospect. You
didn't get the term sheet you were expecting. Your web site has been down for hours.

What do you do?

All entrepreneurs know that running a startup company has its ups
and downs. However, how a CEO handles the downs is very important. If there's one thing I've learned, its that a
CEO needs to share the bad news with investors just as fast as they share the
good news.

I'm a big believer in creating transparency between a
CEO and his board of directors. At
Half.com, we created an automated email to summarize our daily sales numbers. In addition to sending it internally to
management, we also sent it our board members. No one expected them to track our sales on a
daily basis (that was my job), but by providing them with the constant flow of
information, they were able to make better suggestions/recommendations when
asked. (That's the same reason why
Jingle Networks distributes a daily email summarizing call volume to
1-800-FREE411).

With the growth of ASP-based management tools, there are
now even easier ways to share information with investors. Several of my portfolio companies have
created accounts on Salesforce.com for Board Members with a customized BOD dashboard to provide a "30,000 foot view" of the pipeline. Other companies have created accounts on
Google Analytics so that board members can access traffic stats in real time.

By providing open access to information sources there are a number of benefits:

It eliminates
surprises. By providing a continual
stream of information, the board should never be surprised.

It makes board
meetings much more productive. Rather
than spend a lot of time presenting the raw data, the CEO can now provide
interpretation and analysis of data -- they can put the numbers in context.

It allows board
members to make more meaningful suggestions. Different board members have different
skills. Some are strong at enterprise
sales -- and by tracking a sales pipeline over time they might be able to
identify areas for improvement in the sales cycle. I personally am stronger at online consumer
marketing -- and feel that by having access to website traffic reporting I can
ask better questions and make better recommendations.

Sharing data with a board does
not mean that you are sharing control. Rather,
I believe that an informed and knowledgeable board will be less intrusive (and more hands-off) than
a board that is in the dark. (That said,
a CEO should clearly set expectations that they are not looking to get the
"why are Tuesday's sales 2% lower than Monday's sales" phone call. )

Too many CEO's try to hide
their bad news and setbacks -- they stick it in the fifth paragraph of a six
paragraph email. I get extremely
uncomfortable with that approach. It
forces the investor into the role of detective -- constantly on the look out for hidden
clues.

Just last week I received an
email from a portfolio company CEO with the subject line "Bad news. XXXX is reversing his previous agreement to
fund us." While no investor likes
to receive bad news, I must say that I was impressed by the way the CEO handled
it. He communicated the news
clearly and boldly.

Over the last few
years, my fund has made over 20 seed-stage investments. While we strive to be the "first
money" into a company, we recognize that we typically don't provide enough capital to
get a company to profitability. So we
invest with the assumption that there will be another "institutional"
(or venture) round after us.

In general, I have a strong preference for Preferred
Equity. While there are a few
circumstances where I would go with a Convertible Note (which I'll outline
later), I believe that:

Preferred equity
better aligns the interest of the Investor and the Entrepreneur.A typical convertible note allows an investor to convert from
debt into equity at some discount to the Series A price (typically 20-40%). I believe that this often has an unanticipated
outcome -- it puts the seed-stage investor and entrepreneur on different sides of the
table. The entrepreneur wants the Series
A price to be as high as possible, while the note holder wants the Series A
price to be as low as possible (since the conversion price of their note will
be based on the Series A price). This misalignment of interest creates a number
of problems for me. Once I invest in a
company, I would like to focus on adding as much value as possible - I want to
help the company refine their strategy and business model. I want to help them build their team. I want to introduce them to business
development partners. I want to help them generate PR. I want to introduce them to
several VCs so they can raise their next round on good terms. However, as a note holder, there is an
economic penalty for adding value -- the more I try to help the company, the
more expensive my equity ultimately becomes. In
effect, I have to pay for any value I help create. If I was an equity holder, those conflicts
would not exist. I would benefit directly
from any value I help create.

Preferred equity
prices in all of the risks facing seed-investorsThere are a number of risks facing every company -
technical risk, execution risk, team risk, marketing risk, customer acceptance
risk, etc. However, I believe that the
#1 risk factor facing seed investors is funding risk. Since I know I am not giving the company
enough money to get to breakeven, I need to assess the probability that they
will be able to raise additional money. In
my opinion, a convertible note does not effectively price-in this funding risk.

Preferred equity
typically does not create liabilities for the venture round.The main reason I'm given when people choose convertible
notes instead of equity is that "setting a valuation for a seed-round makes it challenging to get a higher valuation for a venture round."
In my experience, as long as the venture
round occurs more than a few months after a seed-round, this is not the case. I have recently participated in several seed-rounds that raised much larger venture rounds at valuations that were multiples of the seed-round valuation. Venture firms understand
that the later they invest, the more progress a company makes, the more risk
gets removed from the deal -- and valuations reflect that. In fact, I often see companies use the progress they've
made during the interim period as a rationale for increased valuation (ie, we
were worth $3M before we had a complete team, a customer pipeline, a working
product -- so now we're worth $5-7M). This, of course, assumes that the terms for the equity are standard market terms. (I prefer to use the National Venture Capital Association's Model Documents -which are drafted to reflect current practices and norms and "avoid bias toward the VC or the company/entrepreneur."

So what are the cases when I'm OK with a convertible
note?

When a VC round
is already underway or imminent.

There are times when a company is already in talks
with a number of venture firms, but wants to take some money in advance of the
round. This money often lets them make
key hires or purchase necessary hardware so that they can have a stronger hand
in their VC negotiations. In these
cases, I'm comfortable participating in a bridge note -- provided that I am
reasonably confident that a venture round will close within the next 60 days.

When I'm not
expecting (or expected) to be an active investor

.While I try to help create value for all my portfolio
companies, there are sometimes circumstances where I am not the lead investor
-- and am not expected to be extremely active. These tend to be situations where I have a
smaller investment and am more "reactive" than "proactive".

When the
discount (or warrant) coverage increases over time

.When I invest in a note, I prefer that the notes
are structured so that the conversion discount (and/or warrant coverage) increases
as time progresses. If a company closes their
venture round two months after I purchased my note, I should get less of a benefit than if takes
the company eight months to raise a VC round.

When the note
has some equity-like protections.Any bridge note should have provisions that (1) prevent
the company from pre-paying the note without the approval of the noteholders
(otherwise I could get redeemed for interest only without converting into the next
round); (2) provide a pre-specified
payment in the event of a change of control prior to a venture round (so if a company
gets acquired before the note converts, the note holders get a return of X);
(3) put a cap on the amount of additional debt a company can take (so you don't
end up with a company that raises millions of dollars via bridge loans); and
(4) provide basic protective provisions. In addition, if I'm leading the seed-round, I
also ask for a maximum conversion valuation -- so that I'm protected if the
Series A valuation is dramatically higher than I expected.

This analysis is by no means comprehensive. But in general, I believe that if an entrepreneur wants a seed-investor who can add real value, it is not productive to economically penalize that investor when they add it. Structuring a seed-round as equity allows the investor and entrepreneur to be completely aligned and share one goal - to create as much value as possible for the company.

So I log in to mybloglog.com today (a great source for
tracking where your blog readers come from and where they go) - and I notice
that I received three visitors from the following Google Query: "early
stage companies bought for high valuations". Nice to see that I'm the only VC to show up on
the first screen of Google results ;-)

Apparently some readers have been subscribing to an old version of my blog's RSS feed. To ensure that you are receiving all new blog posts, please make sure your RSS feedreader is subscribed to http://feeds.feedburner.com/redeyevc. I apologize for any problems this might have caused you...

On the First Round Capital website we write that: "We love investing in technologies and
business models that are able to shrink existing markets. If your company can
take $5 of revenue from a competitor for every $1 you earn – let's talk!" I’ve often been asked what we mean by that –
so I thought it would be a good topic for a blog post.

My first company, Infonautics, was an online reference
and research company targeting students (mostly high school students). While I was there, I got a firsthand
education on “asymmetrical competition.” In 1991, when we started Infonautics, the encyclopedia market was
approximately a $1.2 Billion industry. The market leader was Britannica - with sales of approximately $650
Million, they were considered the gold standard of the encyclopedia market
containing “over 44 million words” written by scholars and “more than 80 Nobel
laureates”. World Book Encyclopedia was
firmly ensconced in second place. Both
Britannica and World Book sold hundreds of thousands of encyclopedia sets a
year for over $1,000.

However, in 1993, the industry was permanently
changed. That year Microsoft launched
Encarta for $99. Encarta was initially
nothing more than the poorly regarded Funk & Wagnall's Encyclopedia
repackaged on a CD – but Microsoft recognized that changes in technology and
production costs allowed them shift the competitive landscape. By 1996 Britannica’s sales had dropped to
$325 million - about half their 1991 levels – and Britannica had laid off its
famed door-to-door sales staff. And by
1996 the encyclopedia market had shrunk to less than $600M. In that year, Encarta’s US sales were estimated at $100M.

So in just three years, leveraging a disruptive
technology (CD-ROM), cost infrastructure (licensed content versus in-house editorial teams), distribution model (retail in computer stores versus a field sales force) and pricing model ($99 versus $1000), the encyclopedia
market was cut in half. More than half a billion dollars disappeared from the market. Microsoft turned
something that Britannica considered an asset (a door-to-door salesforce) into a liability. While
Microsoft made $100M it shrunk the market by over $600M. For every dollar of revenue Microsoft made,
it took away six dollars of revenue from their competitors. Every dollar of Microsoft’s gain caused an
asymmetrical amount of pain in the marketplace. They made money by shrinking the market.

[It is also interesting to note how distruptive business models have continued to impact the encyclopedia market - anyone care to guess what Google and Wikipedia have done to Encarta sales in the last few years?]

At Half.com, we tried to do the same thing. We quickly learned that most readers of
fiction books finished reading the book within two weeks after purchase. So we launched a very simple feature on our
site. Say you purchased a John Grisham
book from half.com for $15 (versus a market price of $30). Two and a half weeks later you would receive
an email from Half.com offering “your money back” – users simply had to check a
box and we would list their book for sale for $15. The vast majority of users would relist the
book for sale -- and we found that for best selling books, we would sell the
exact same copy of a book four times. That
is, Buyer A would buy the book for $15, read it and sell it to Buyer B for $15,
who would then read it and sell it to buyer C for $15, who would read it then
sell it to Buyer D. Of course, we would
take commissions from every sale – say $3 – and shipping charges – say $2 –
from each sale. So for the four transactions,
the out of pocket cost to the buyers would be $20. Now if half.com didn’t exist, you can assume
that the books would have been purchased through traditional channels for $30
each – for a total out of pocket cost of $120. Think about it. For every $1
of sales on half.com, we took $6 away from the existing traditional
channel - another example of asymmetrical
competition.

This is the reason why I’m so excited about our recent
investment in Jingle Networks. Jingle is
the owner of 1-800-FREE411 – the country’s first nationwide provider of free
directory assistance. Launched late last
year, the 1-800-FREE411 service offers consumers a free alternative to the high
cost of 411 service provided by traditional carriers. By including a ten-second
advertisement before giving out a phone number, 1-800-FREE411 saves consumers
on average $1.25 each time they look for a phone number from their telephone.
Since American consumers use traditional 411 services 6 billion times a year,
1-800-FREE411 has the potential to shrink an $8 billion market. I
believe (and hope) that as consumers shift to ad-supported directory
assistance, we will take a significant share away from
the entrenched carriers.

If you have a business that will shrink an existing
market, allowing you to take $5 of revenue from a competitor for every $1 you
earn, let’s talk!